What Is A Value Stock? How To Identify A Value Stock?

By: Rupesh Oli

“Price is what you pay. Value is what you get.” – Warren Buffet

Value Stocks: The underdogs of the investment world waiting for the perfect opportunity to showcase its true worth/potential and prove themselves as one of the worthwhile investment opportunities – in fact – the majority of investors miss out on.

What is a Value Stock?

A value stock is a stock of a company with the share price currently trading below its fundamentals. Also referred to as undervalued or bargain-priced stocks, an investor can determine whether a particular stock falls under the category of value stock or growth stock with the aid of various financial metrics. Growth stock possesses the contrasting trait when compared to value stock, simply consider it as the exact opposite of value stock. Investors invest in value stock with a notion that the price will eventually rise denoting its true potential resulting in profits for them in between.

When investing in value stocks, you must embrace it as a long-term and conservative approach to investment. It is because you will be buying and holding the companies whose stock prices are currently trading below the intrinsic value. You will not be acting as a trader, the one who frequently performs buying and selling in the market based on the price fluctuations, no matter it be through short selling, or simply buying low and selling high, or buying high and selling even higher. Since the value stocks are traded on the market at the price below the true value, it indicates a worthwhile investment opportunity for the investors. Most often, value stocks are found to be the established companies with a virtuous reputation in terms of financial performance over the years thereby considered to be the soundest investment option.

Suppose you are considering buying a new laptop to optimize your day-to-day life efficiently, be it your work life or study. You researched and came to know about the actual price of the particular laptop you are going to buy. After a couple of days, you saw the laptop available on sale at a discounted price. You then changed your plan and instead of buying the laptop and using it for your academic or work purposes, you decided to grab the offer and sell it later at a higher value. This is how exactly value investing for stocks operates in action. You buy the stocks at the discounted rate and hold them till the time it reaches their true worth and reap the rewards afterward. However, unlike advertisements for a laptop which I just demonstrated, value stocks won’t be displayed to the public and provide the hint so easily for you to buy it. Instead, you have to do all your homework and come up with a list of value stocks based on their characteristics which will be elaborated on in the latter section.

Note: You must never take the value stocks lightly considering it to be the cheaper or low-priced option. It is because the stock price of a company doesn’t accurately reflect its true worth. As the stock prices heavily deviate from what the fundamentals actually suggest, investors either overpay or underpay for their investments. If they underpay for the stock knowingly or unknowingly, it can be considered a worthy investment, if not, they definitely overpay for the stocks denoting it as not the best-suited decision.

You May Also Like:

Value Investing & The Investment Discipline

Contrarian Investing Strategy: How Well Does It Work?

How To Identify the Value Stocks: Characteristics Of A Value Stock

1. P/E Ratio

P/E (Price-to-earnings) ratio calculated by dividing stock price of a company by its EPS (Earnings Per Share) indicates how much you need to spend in order to grab per dollar (or any other currencies) of a company’s annual earnings. P/E ratio helps determine whether the stock price of a company truly justifies its earning potential or not. A low P/E ratio can be considered a powerful indicator in determining a particular stock is undervalued (value stock).

To make sure a particular company possesses a low P/E ratio, you can compare with other competitors of the same industry or the industry average.

2. P/B Ratio

P/B (Price-to-book) ratio calculated by dividing per stock price of a company by its book value per share compares the net value/book value (assets-liabilities) of a company to its market capitalization. P/B ratio indicates to what extent the investors are willing to pay for each dollar of the company’s net value. A low P/B ratio may indicate an undervalued stock in the market.

3. D/E Ratio

D/E (Debt-to-equity) ratio, calculated by dividing liabilities of the company by its shareholder equity, measures the company’s debt against its assets. A low D/E ratio refers to a company using a lower amount of debt for financing, which is indeed a good signal and vice-versa. Too much debt can indicate a sign of risk. As previously said, a low or high D/E ratio depends on the industry the particular company is operating based on the competitor’s performance. A high D/E ratio may not be necessarily a bad indicator as a company might utilize the debt amount to expand its operation to optimize its future prospects.

You might be wondering how D/E actually helps in figuring out the undervalued stocks. Well, the D/E ratio is more inclined towards determining the financial strength of the company from the perspective of debt it has acquired and how it has utilized those debt amounts for its upliftment. Hence, the D/E ratio too must be taken into consideration along with other ratios to filter out the utmost value stock.

4. P/S Ratio

P/S (Price-to-Sales) ratio is calculated by dividing the market capitalization of a company by its total sales/revenue in which market capitalization simply refers to per stock price multiplied by total outstanding shares. A low P/S ratio can be taken as another indicator to hunt out the value stocks.

5. PEG Ratio

PEG (Price-to-Earnings Growth) ratio, calculated dividing P/E ratio of a company by its percentage growth of annual EPS, incorporates the historical growth rate of a company’s earnings instead of merely looking at the price and earnings. A low PEG ratio could potentially indicate an undervalued stock as the price of that particular company is low when compared to its expected earnings growth.

6. Free Cash Flow

The net cash generated by the company after deduction of all the operating and capital expenditure is known as free cash flow. Free cash flow can be utilized for future investments, dividends payments, paying off the existing debts, etc. If you can discover the companies with a low stock price; however, plenty of free cash flow, you are good to go.

7. Dividend Yield

Simply, dividend refers to the sum of money paid, most often, on the annual basis by the company to its shareholders out of its profits or reserves. Dividend yield, on the other hand, refers to the dividends you would be receiving from the particular stock expressed as the percentage rate. Good value stocks have a history of delivering consistent dividends ultimately leading to a high dividend yield. It refers to the stability and substantial profit-generating capability of that particular stock.

Since value stocks are older and more established companies, they provide higher dividend yields than their counterparts. However, you need to figure out whether the company is delivering consistent or inconsistent dividends, if the second scenario prevails, you need to work out to find out the ones with consistent dividends.

8. Future Prospect

Rather than solely basing your decision based on financial metrics, value stocks too can be discovered via their future prospect. To determine whether a particular company possesses a bright future prospect or not, you can research the company’s vision in upcoming years, its plans and projects, the strength of the management team, business principles, etc. If it is something that signals towards a potential investment option, you must take it as a perfect opportunity. One of the famous quotes of Warren Buffet states- You should never invest in a company if you do not understand it. Hence, do your research and come up with the decision rather than investing blindfolded.

If we try to summarize all the characteristics under the single umbrella – at a glance – value stocks can be characterized based on low P/E ratio, low P/B ratio, optimal D/E ratio, low P/S ratio, low PEG ratio, high free cash flow, consistent dividend, high dividend yield and bright future prospect of a company.

6 Financial Ratios To Look Into Before Investing In Stocks

Value Investing and Value Stocks

Simply, value investing refers to the investment in value stocks. Once you are able to spot the value stock based on its characteristics, you then decide to invest in that particular stock thereby leading you towards the adoption of a value investing strategy. This approach of investing allows you to grab the stock on – what’s known as – margin of safety, which refers to the availability of stock on the discount of market price to its actual intrinsic value. Rather than grabbing the generic company’s stock at a bargain price, you should be focusing on finding out the outstanding companies at a sensible price.

You need to have patience and persistence when it comes to value investing. It is because you will definitely not be able to amass huge returns within a couple of weeks/months after your investment. Instead, value stocks work best for buy and hold investment strategy. You are buying the stocks not for the short-term gain, however, for the better future payoff. From a return perspective, value stocks are very rewarding, most of the time. Indeed, you can enjoy the power of compounding as the number of stocks you possess gets multiplied over time with bonus dividends. Due to the less volatile nature of value stocks, it takes time to show its real potential as its price fluctuations are minimal compared to growth stocks implying its stock price increases at a low pace. It is because value stocks are well-established household names existing in the market over the long haul with a good reputation, often many times, known as blue-chip stocks, too. As a result, it depicts less volatility.

As an investor, you need to consider the fact that the market overreacts to the contemporary context, whether it be on the good or bad news, resulting in stock price fluctuations. It is, therefore, cannot be correlated to the company’s fundamentals and its long-term potential. So, study the stock by its fundamentals, rather than following the herd. You may lag on short-term gain, but you undeniably outshine the rest of the herd on the long-term gain with enormous capital appreciation. As a value investor, you need to think like a detective to discover the stocks that are currently on secret sale and seize them at discount. When the market values them, you are miles away from the remaining herd and would have leveraged so much.

Most of the time, I referred to the terminology ‘intrinsic value’. So, what exactly intrinsic value is?

It is a measure of what an asset is truly worth of. In the case of stock, you can use a combination of various financials such as cash flow, revenue, earnings, profit along with the financial ratios which I just demonstrated above along with external factors like industry performance, competitive advantage, moat of business, business model, etc. and so on. If a company’s current stock value falls below its intrinsic value, you have discovered the value stock that can be considered as a worthwhile investment option.

Greatest Value Investors of All Time

Undeniably – as far as I am concerned – Benjamin Graham and Warren Buffet are the greatest value investors of all time. Benjamin Graham advocated the concept of value investing in his book The Intelligent Investor, considered as the bible of value investing till date. Even Warren Buffet considers Graham as the greatest of all time and always admires him as a mentor. Both sorted out the companies with market prices less than the intrinsic value, strong fundamentals, and bright future prospects which helped them to consistently beat the market return over the haul.

Other successful value investors include Bill Miller, Seth Klarman, Mohnish Pabrai, John Neff, Howard S. Marks etc.

Criticisms

To point out some of the criticisms of value investing, value stocks might not always beat the return of growth stocks as the data of the late 1990s reveal. Further, when you tend to buy the value stocks on the bear market, stock prices still dip down in accordance with the market. However, this cannot be considered as an issue for value investors, as we tend to focus on buy and hold strategy for value stocks rather than trading.

At the End

Lastly, value stocks are the ones that you need considering including in your portfolio as it has a huge potential based on the returns they will be delivering over the period. In the previous article where I wrote about growth investing and growth stocks, value stocks along with growth stocks can be considered as one of the best approaches when it comes to the selection of stocks. However, it all boils down to investors’ preference at the end whether they want to go solely towards value investing or growth investing. If not, the hybrid investment approach with the inclusion of both the value and growth stocks can be considered as the preferable option to go for.

From The Author:

Barbell Investment Strategy: Explained

Important Skills Required to Become a Successful Investor/Trader

(Liked this article??? If you are also interested in publishing your articles related to business, finance, and economics, then mail us your article at Investopaper@gmail.com.)